Gimme Shelter

AMID THE FEARS about a housing bubble, the weak economy, the stock market and potential war with Iraq,
Toll Brothers,
the country's largest builder of luxury homes, is seeing no slowdown in demand.

The company is on track for record earnings of about $3.20 a share for its fiscal year ending in October, up from $2.91 in 2002 and just 42 cents a decade ago. Toll aims to generate a record $2.6 billion in revenue this year, while delivering 5,000 homes, up from 4,430 in fiscal 2002 and 1,324 in 1993 (see table).

Despite Toll's enviable decade-long growth record -- which compares favorably with that of technology giants
Oracle,Microsoft
and
Cisco Systems
-- and its still-bright prospects, its stock has been languishing around 20, down from a peak of 32 in May. Toll trades at only six times projected fiscal 2003 profits and just 1.3 times its book value of $15 per share. Toll's return on equity has topped 20% in all but one of the past 10 years.

Toll, based in Huntingdon Valley, Pa., is depressed because Wall Street fears its focus on the luxury market -- its average house sold for $514,000 last year, compared with about $225,000 for most major builders -- makes it vulnerable to the spreading white-collar recession. Investors also are worried that Toll's industry-leading net margin of 9% is apt to slide if housing prices slip in the high-cost states where the builder is concentrated.

The Street fears the home market may follow the path of the already soft commercial real-estate and residential rental markets. There's also worry that Toll, whose operations once were concentrated within a few hundred miles of its headquarters outside Philadelphia, may be expanding too rapidly in places such as Florida, Arizona, California and Colorado. It operates in 22 states.

One cautious analyst, Michael Rehaut of J.P. Morgan, fears a slowing order book in this year's first half and a "more challenging pricing environment."

Thursday, Toll announced a record order backlog in its 172 developments, but tempered that optimism with word that buyers lately have been reluctant to make deposits on new homes.

Selling the American Dream: Toll Brothers builds spacious homes for affluent families in all major regions of the country. From top left to right, a columned Georgian-style house in North Carolina, a brick home in Michigan, a colonial in New York, a Tuscan-style house in Florida, and a Spanish-themed home in Arizona.

Toll may indeed face a tougher future, but its fans say the bearish scenario is already reflected in its share price. "Toll is significantly undervalued. It has a consistent record of generating high returns and high growth," says Matthew Lindenbaum, a managing partner at Basswood Partners, a New York investment firm that owns 1.9 million shares.

Lindenbaum says the stock is worth 36 and could top 30 in the next year. One of Toll's virtues, he argues, is its rapidly rising book value, which should hit $18 a share by the end of the current fiscal year and top $20 in 2004. The growing book value is apt to put a floor under Toll's stock around current levels, he believes.

Toll's fiscal 2003 profit is largely in the bag, given the company's strong order backlog. Toll engages in little speculative building, preferring to wait until a buyer puts up a nonrefundable deposit of 7% to 10% before starting work.

The outspoken Robert I. Toll, the company's co-founder and chief executive, is mystified by the stock price. "It's trading below liquidation value," he says. "When this industry gets the recognition it deserves, our P/E will be 20, not six." It should be said that Toll shares a low valuation with other home builders. Industry adherents such as John Neff, a member of the Barron's Roundtable, argue that the entire group is appealing.

Toll's book value, moreover, probably is understated because its considerable land holdings are carried at their cost of about $800 million, not their appreciated market value. Toll's book probably would rise by $2 to $3 a share if the land were marked to market. Toll controls 40,000 lots, sufficient for eight years of home output at its current rate of production.

A bullish Toll says his company's annual revenue and profit can grow at a 15% clip over the next several years. "We could triple the size of the company without changing our standard method of operation," he says. Earnings and revenue have climbed by 20% a year since Toll went public in 1986, even though the company hasn't made any major acquisitions -- not bad for a supposedly cyclical business.

A case can be made that Toll deserves to trade at a premium to its peers because of its differentiated business model and scarcity value. While most major home builders cater to first-time buyers, Toll focuses exclusively on the high end. About 70% of its homes are in the $300,000 to $700,000 range.

Toll is controlled by the aforementioned Robert, 62 years old, who owns 12 million shares and his brother, Bruce, who co-founded the company in 1967. Bruce, 59, a holder of eight million shares, is vice chairman but plays no management role. The brothers own over 25% of the 75 million outstanding shares.

Toll's modest market value of $1.5 billion, its strong niche and its low valuation could make it a takeover target, but Robert Toll expresses no desire to sell: "I'm having a great time. I don't think in terms of selling the company." As for the housing bubble, there isn't any, Toll says. "Barring a calamitous change in the economy, housing won't go in the dustbin because of the tremendous growth in demand and constriction in supply."

Toll makes a persuasive case that housing, a bright spot in the economy, isn't about to undergo a major slowdown. New household formations and strong immigration are creating demand for 1.7 million new homes annually, while single-family housing starts are running at a pace of 1.3 million a year.

No-growth and anti-sprawl sentiment is spreading, restricting building activity. New Jersey Gov. Jim McGreevey went as far as to say that "there is no single greater threat to our way of life in New Jersey" than sprawl. McGreevey blasted "unrestrained, uncontrolled development" that is crowding schools, congesting roads and driving up taxes.

"McGreevey is a bright guy who probably knows better," Toll says. In New Jersey, a builder like Toll needs to get 150 different permits to turn virgin land into a new "community" of homes. This process can take six years and involve numerous modifications sought by increasingly contentious local governments. "Is that unrestrained and uncontrolled development?" Toll asks. The laborious process gives an experienced Toll an edge over smaller builders, and also helps create scarcity value for its homes in anti-sprawl areas.

Toll has diversified away from big homes designed for the "move-up" market, which now account for about 60% of its production. Many of its developments target empty-nesters, while others are geared toward "active adults" over 55. These communities often include golf courses.

Toll has positioned itself as a "nearly custom" builder. It curbs costs by offering a limited choice of home styles and layouts and by using its size to extract concessions from suppliers. One of Toll's advantages is that it mass-produces walls, roof trusses and other structural elements, trimming costs and speeding construction. Yet buyers can customize by selecting from hundreds of options.

Toll homes are spacious and impressive, averaging more than 3,500 square feet. Toll can profitably sell them for less than $700,000 in all but the most expensive parts of the country. In the view of traditionalists, Toll homes are inferior to the stately 1920s colonials and Tudors with slate roofs and plaster walls found in many older East Coast and Midwest suburbs. Some critics even call Toll-type homes soulless "McMansions" -- think the Sopranos' abode. But such homes are coveted by many Americans. Robert Toll notes that his target market -- families with incomes of $100,000 or more -- totaled 15 million in 2001, versus 4.6 million in 1981 (adjusted for inflation).

With land scarce in established suburban areas around New York, Philadelphia and Washington, Toll is developing communities farther from major cities. A small one is in Basking Ridge, N.J., about 40 miles from Manhattan, where Toll is completing 55 homes, each on a one-acre lot. A typical four-bedroom home there is a stone-front, center-hall colonial with a grand entry foyer, Corian kitchen counters and a Jacuzzi in the master bath.

Toll buyers typically add 20% to the purchase price by choosing options such as granite countertops, marble bathroom floors or 10-foot ceilings (nine-foot is standard), or additions such as music rooms. The Basking Ridge homes sell for $1 million, reflecting high land costs; an acre in the town can fetch $500,000.

High-end buyers tend to be pickier than eager first-timers. Still, Toll claims a 95% satisfaction rate, although there have been isolated problems, such as charges of shoddy construction made by Boston-area buyers several years ago.

Housing may hit potholes, but over time, there have been fewer better investments. A bet on Toll is a wager on upward mobility and home ownership, the American dream.

That's almost never been a bad bet.

Gimme Shelter

Toll Brothers' high-end home-building business doesn't look like a
bubble

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